How the Bid-Ask Spread Eats Your Profits in Illiquid ETFs

If you are an Indian retail investor, chances are you’ve caught the passive investing bug. Over the past few years, the narrative has been loud and clear: skip the underperforming active mutual funds, embrace the low expense ratios of Exchange Traded Funds (ETFs), and let compounding do the heavy lifting.

But fast forward a few years, and you might notice something frustrating. While the underlying index your ETF tracks has soared, your actual portfolio returns seem to lag behind. You check the expense ratio—it’s barely 0.20%. So, where did your money go?

The culprit is a silent, often overlooked profit-killer known as the bid-ask spread, and in the less liquid corners of the Indian ETF market, it is eating your wealth alive.

The Invisible Tax on Your Returns

To understand the bid-ask spread, imagine walking into your local neighborhood jeweler to buy gold. The jeweler will quote you two prices: one if you want to buy a gold coin (the “Ask” price) and a slightly lower one if you want to sell that same coin back to him (the “Bid” price). The difference between the two is the jeweler’s profit margin.

The stock market works precisely the same way. When you buy an ETF on the National Stock Exchange (NSE) or Bombay Stock Exchange (BSE), you pay the “Ask” price. When you sell, you get the “Bid” price. The difference between the two is the bid-ask spread.

In highly liquid ETFs—like those tracking the Nifty 50 or Sensex (think NiftyBeES)—millions of units change hands daily. Because there are thousands of buyers and sellers, the spread is razor-thin, often just a fraction of a paisa. You buy and sell at prices almost identical to the ETF’s true underlying value.

But the Indian ETF market is heavily skewed. Outside of the top 10-15 broad market funds, liquidity drops off a cliff.

The Illiquidity Trap in Niche ETFs

As Indian investors have become more sophisticated, Asset Management Companies (AMCs) have flooded the market with specialized products. Today, you can buy Sectoral ETFs (like Healthcare or IT), Thematic ETFs (like ESG or PSU Banks), Smart Beta ETFs (like Nifty Alpha 50 or Low Volatility), and International ETFs tracking the Nasdaq 100 or Hang Seng.

While these sound great on paper, many of these niche ETFs suffer from incredibly low daily trading volumes. Some might only trade a few thousand units a day.

When trading volumes are low, the market makers—the institutional entities appointed by AMCs to provide liquidity by continuously offering to buy and sell—take on more risk. If they buy your shares, they might get stuck holding them because there are no other buyers around. To compensate for this risk, market makers widen the bid-ask spread.

It is not uncommon to see illiquid thematic or international ETFs in India trading with spreads of 1%, 2%, or even higher.

How It Destroys Your Compounding

Let’s put numbers to the pain. Suppose you decide to invest ₹1,00,000 in a niche Smart Beta ETF that has a 1.5% bid-ask spread.

The moment your buy order executes, you’ve effectively paid a 0.75% premium over the true value of the fund. Years later, when you decide to sell your holdings to fund a goal, you take another 0.75% haircut on the way out.

That is 1.5% of your total capital vanished into thin air. If you trade frequently or try to rebalance your portfolio using illiquid ETFs, this friction acts as a massive drag. Over a 10 or 20-year investing horizon, that 1.5% “invisible tax” compounds into lakhs of rupees in lost wealth, completely negating the benefit of the ETF’s low expense ratio.

The Premium/Discount Danger: iNAV vs. Market Price

The spread isn’t the only danger. Illiquidity often causes an ETF’s market price to completely decouple from its actual value.

Every ETF has an iNAV (Indicative Net Asset Value), which is the real-time, fair value of the underlying stocks held by the fund. Exchanges like the NSE publish this number every few seconds.

In a highly liquid ETF, the market price closely tracks the iNAV. But in illiquid ETFs, sudden retail demand can push the market price significantly higher than the iNAV. If you blindly place a “Market Order” to buy on your brokerage app, you might end up paying a massive premium—sometimes 3% to 5% more than the underlying stocks are actually worth! When the hype dies down and you go to sell, the ETF might be trading at a discount, forcing you to sell for less than fair value.

SEBI Steps In: The Push for Better Price Discovery

The Securities and Exchange Board of India (SEBI) has been acutely aware of these liquidity and pricing distortions. Recognizing that retail investors were getting the short end of the stick, the regulator has introduced robust market-making requirements and dynamic trading norms to protect investors.

Under the latest frameworks (including the significant dynamic price band overhauls), SEBI is shifting the base price for ETF price bands from outdated T-2 NAVs to more accurate, real-time Volume Weighted Average Prices (VWAP). They are also mandating dynamic price bands that flex intelligently rather than hitting rigid 20% circuits, which historically caused ETFs to freeze at distorted prices.

Furthermore, AMCs are under strict mandates to ensure their appointed Market Makers provide continuous, tight two-way quotes to ensure the market price stays tethered to the iNAV.

How to Protect Your Profits

While regulatory frameworks are improving, the ultimate responsibility for protecting your wealth lies with you. Here are four unbreakable rules for trading ETFs in the Indian market:

1. Never Use Market Orders

This is the cardinal rule of ETF investing. A market order tells your broker to buy or sell at any available price. In an illiquid ETF, this could trigger a trade far away from the fair value. Always use Limit Orders. Decide the price you are willing to pay, enter it into your app, and let the trade come to you.

2. Always Check the iNAV Before Trading

Before you hit “buy” or “sell,” find the iNAV. Most modern Indian brokerages and the NSE website display it alongside the ETF quote. Set your limit order as close to the iNAV as possible. Never knowingly pay a massive premium.

3. Stick to Liquid Funds for Your Core Portfolio

If you want hassle-free investing without constantly monitoring spreads, stick to the giants. Broad market index ETFs tracking the Nifty 50, Sensex, or Nifty Next 50 usually have deep liquidity, tight spreads, and heavy market-maker presence. Keep the niche, illiquid ETFs to a small satellite portion of your portfolio, if you use them at all.

4. Time Your Trades Wisely

Avoid trading ETFs during the first 30 minutes of the market open (9:15 AM - 9:45 AM) and the last 30 minutes before the close (3:00 PM - 3:30 PM). During these windows, underlying stocks can be highly volatile, and market makers often widen their spreads to protect themselves from sudden swings. The safest time to trade is mid-day, when the markets are relatively stable.

The Bottom Line

ETFs remain one of the greatest wealth-building tools ever created for the retail investor. They offer diversification, transparency, and low costs. But in the Indian market, low expense ratios are only half the battle.

By understanding the bid-ask spread and refusing to pay the hidden costs of illiquidity, you can ensure that the compounding engine you’ve built works for you, rather than enriching the market makers. Treat your ETF trades with the same scrutiny you would apply to buying physical gold, and your future portfolio will thank you.

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